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Master Course: Liquidity Management: Liquidity Risk

Liquidity Risk

Liquidity risk is the potential for loss to a company arising from the company’s failure to pay its debts and obligations when due because of its inability to convert assets into cash or its failure to procure enough funds at a reasonable cost. The problem could also be the result of a market disruption or liquidity squeeze whereby the company may only be able to unwind specific exposures at significantly discounted values. Liquidity risk can be quantified by multiple approaches.

Liquidity Risk Measurement Tools

Cost to Close

The cost to close concept originates from the rate gaps that exist between assets and liabilities. The concept illustrates that the gaps that exist in interest rate sensitive assets and liabilities needs to be closed out as they create liquidity risk for the current portfolio. If the gap is negative in a particular bucket, it means that rate sensitive assets in the bucket are less than rate sensitive liabilities. The liabilities in that bucket need to be settled but adequate assets to match those liabilities are not present. Hence the institution needs to go out in the market and borrow money to settle the excess liability and close the gap.

The gap is to be closed by borrowing on the going interest rate in the market. For example, a negative gap in the 1 month bucket will be closed by borrowing short term for one month at interbank rate. The amount will essentially be borrowed at a spread over a benchmark market rate.

Rate Sensitive Gap

Rate sensitivity measures the responsiveness of the asset and liability portfolio to changes in interest rates. Rate sensitive assets and liabilities thus are instruments whose values are impacted by changes in market interest rates. These may include both on balance sheet as well as off balance sheet items. Rate sensitive gap is the difference between the book values of rate sensitive assets and liabilities and is calculated for various maturity buckets as well as cumulatively across buckets.

Fixed rate instruments may be adversely affected by changes in interest rates throughout their tenor, whereas floating rate instruments may be adversely affected by changes in market interest rates between repricing dates. Therefore in the calculation of rate sensitive gap, fixed rate instruments are slotted into the various maturity buckets based on the days remaining to maturity whereas floating rate instruments should ideally be slotted into the relevant maturity buckets based on the days remaining to the next reset/ repricing date.

Price Sensitive Gap

This report calculates the economic value of balance sheet item. It computes the mark to market value of the balance sheet items on the revaluation date and then re-prices the items using the term structure with basis point shifts. The difference (i.e. the gain or loss) for the price sensitive items reflects the impact on the economic value of equity. The difference in values is used to calculate the percentage loss in market value of the items. Each item is slotted as per its days to maturity in its respective maturity bucket.

Liquidity Gap

This approach evaluates the liquidity gap and assesses the overall concentration of assets and liabilities across the maturity buckets. The methodology followed is similar to rate sensitive gap however here the focus is on liquid assets and liabilities rather than rate sensitive assets and liabilities.

Liquidity Ratios and Analysis

Current Ratio

This is the proportion of current assets that cover current liabilities. It is calculated to ascertain whether the company’s short term assets are readily available to pay off its short term liabilities. It is given by the following formula: Current Ratio =Current Assets ÷ Current Liabilities

Theoretically the higher the current ratio is the better. However as this can be misleading because it could take time to liquidate the assets, in evaluating the current ratio, the company will also look at the composition of its current assets to assess how quickly they can be converted to cash to cover the current liabilities

Quick Ratio

This is a supplement to the current ratio and compares highly liquid assets with current liabilities. It is more conservative than the current ratio because it excludes current assets which are difficult to convert quickly to cash. A higher ratio means a more liquid current position. It is given by the following formula: Quick Ratio = Quick Assets÷ Current Liabilities, where quick assets are cash, marketable securities and accounts receivable.

About the authorJawwad Farid

Jawwad Farid has been building and implementing risk models and back office systems since August 1998. Working with clients on four continents he helps bankers, board members and regulators take a market relevant approach to risk management. He is the author of Models at Work and Option Greeks Primer, both published by Palgrave Macmillan.Jawwad is a Fellow Society of Actuaries, (FSA, Schaumburg, IL), he holds an MBA from Columbia Business School and is a computer science graduate from (NUCES FAST). He is an adjunct faculty member at the SP Jain Global School of Management in Dubai and Singapore where he teaches Risk Management, Derivative Pricing and Entrepreneurship.